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The Top 1 Percent

This article originally appeared in the Washington
Times on June 19, 2005.

The first in a recent series of New York Times articles about
“class in America” claimed “the after-tax income of the Top 1
percent of American households jumped 139 percent, to more than
$700,000, from 1979 to 2001, according to the Congressional Budget
Office” (stopping at 2001 because the figure for 2002 fell to
$631,700).

A recent article in the same paper used a black box “computer
model” to slice the pie even thinner, down to the top 145,000
taxpayers. Author David Cay Johnston concluded, “The average income
for the top 0.1 percent was $3 million in 2002. … That number is
2? times the $1.2 million, adjusted for inflation, that group
reported in 1980.”

I criticized the first New York Times article in a May 18 Wall
Street Journal piece, partly because the ephemeral incomes of a few
entertainers, athletes and investors had nothing to do with the
series’ theme of upward mobility among the general population. More
to the point, I cryptically suggested it is inappropriate to use
income tax statistics to measure long-term changes in income
inequality. That needs more explaining.

Unlike Census statistics, the tax statistics include capital
gains — but only those gains that are realized and taxable. This
is particularly deceptive when comparing recent years with 1979-80,
because Individual Retirement Accounts began in 1981, and 401(k)
and Keogh plans came later.

Unlike 1979, most capital gains now accumulate invisibly in
tax-deferred plans for retirement and college. Since 1997, couples
may repeatedly realize capital gains of up to $500,000 from selling
their homes, yet those gains are likewise missing from “income” as
measured by the New York Times.

Because most people now accumulate most capital gains and
dividends in ways undetectable on tax returns, tax data wrongly
suggest only the very rich (whose investments exceed the caps on
401(k) and Keogh contributions) still appear to be realizing many
gains. This creates a statistical illusion only those at the top
appeared to benefit much from the 1982-2000 boom in stocks and
bonds.

A related problem motivated the New York Times’ allusion to
growth in “after-tax income of the Top 1 percent, as estimated by
the Congressional Budget Office (CBO). The reason after-tax income
appeared to rise faster than pretax income was not because of
reductions in personal tax rates on salaries and capital gains —
which brought in more money from the rich rather than less. It was
because of big reductions in effective corporate tax rates after
1981. The CBO had to assign those corporate tax cuts somewhere, so
they did so on the basis of who had the most “interest, dividends,
rents and capital gains” in tax returns.

Recent tax data exclude trillions of dollars average families
hold in tax-deferred retirement and education savings plans,
however, not to mention nearly all capital gains on homes.
Ownership of stocks and homes is now far more widely dispersed
among families with modest incomes than in 1979.

Unable to detect these investment returns from Internal Revenue
Service data, however, the CBO assumed the opposite — the Top 1
percent must be collecting a rising share of investment returns.
They estimated the Top 1 accounted for 53? percent of investment
returns in 2002, up from just 37.8 percent in 1979. As a result,
they estimated the effective corporate tax rate attributed to the
Top 1 percent of households fell from 13.8 percent in 1979 to 6.1
percent in 2002. This dubious gift of corporate tax cuts to the Top
1 percent inspired the Times to refer to that group’s alleged 139
percent growth in after-tax income through 2001 rather than the 98
percent increase in pretax income through 2002.

Even if income figures from tax returns were credible, it would
still be extremely misleading to compare arithmetic (mean) averages
among the Top 1 percent in 1979 with the averages among a quite
different Top 1 percent in 2001 or 2002.

As I wrote in the Wall Street Journal: “It is statistically
dubious to compare long-term growth of average income in any top
income group with growth below. Only the top group has no income
ceiling, and the lower income limit defining membership in that top
group rises whenever incomes are rising.”

In all other income groups, large income increases result in
more people moving into the next higher income group. When that
happens to many people — because incomes generally are rising —
it soon takes more money than before to qualify to be counted among
the second, third and fourth quintiles (fifths) of the income
distribution.

The rising income ceiling at the top of each quintile
becomes a rising floor defining entry into the next
highest quintile. Since the Top 1 percent has no ceiling, the mean
average can easily be dominated by a tiny fraction at the top (as
Mr. Johnston’s figures show), so this “average” is not typical of
the group.

Over long periods, changes in the mean average of the Top 1
percent are largely explained by the fact all lower-income groups’
rising income ceilings must become the Top 1 percent’s rising
floor. In 1979, households needed a “comprehensive income” of only
$144,500 (in 2002 dollars) to be included in the CBO average income
of the Top 1 percent, of $474,300 before taxes. In 2002, households
needed a comprehensive income above $228,400 to be included in the
average, which the CBO estimates at $938,100 in 2002.

Because it took almost twice as much income to be counted among
the Top 1 percent in 2002 as in 1979, nobody should be surprised
averages of all income above that doubled threshold likewise almost
doubled. Suppose we averaged all incomes above $228,000 today, and
then averaged all incomes above $474,300. Wouldn’t the second
figure would be much larger than the first?

These are just a few reasons it is singularly inappropriate to
use realized capital gains and other statistics from income tax
returns to determine the arithmetic average of income among the Top
1 percent, much less to then compare such a flawed figure with some
incomparable figure from 1979.

There are no good estimates of typical incomes among the Top 1
percent, but that is no excuse for repeatedly abusing innocent
statistics.